Volatility Seen as Inevitable as VIX Calls at 6-Year High

May 27 (Bloomberg) -- Traders are loading up on VIX call
options as history shows there’s a good chance stock-market
volatility is about to increase.

Calls on the Chicago Board Options Exchange Volatility
Index, which become more valuable during times of market stress,
outnumbered ones betting on a decrease in market swings by 3.4-to-1 this month, the most since 2008, data compiled by Bloomberg
show. The VIX has closed below 15 for the past 27 days. A study
from Sundial Capital Research Inc. shows the gauge usually rises
after reaching such low levels.

While investors are preparing for market turbulence,
overall trading has been calm for most of the year with the
Standard & Poor’s 500 Index holding near a record. The
tranquility won’t last much longer amid concerns over slowing
economic growth and tensions between Russia and Ukraine,
according to Donald Selkin, chief market strategist at National
Securities Corp.

“There are lots of skeptics out there that think because
of Ukraine or because gross domestic product was a bad number or
because of earnings, stocks might be overvalued,” Selkin, who
helps manage about $3 billion at National Securities, said in a
May 22 phone interview from New York. “The possibility of a
correction becomes greater.”

VIX Calls

Traders use the VIX as a tool to protect their stock
holdings from losses because the gauge moves in the opposite
direction of the S&P 500 about 80 percent of the time. The
measure tracks the cost of S&P 500 options, which become more
expensive when expectations for volatility increase.

The VIX fell 8.7 percent last week to 11.36, closing about
2 points from an all-time low. There are about 5.5 million calls
outstanding on the gauge, compared with 1.7 million puts, data
compiled by Bloomberg show.

The index jumped 1.3 percent to 11.51 at 4:15 p.m. in New
York. The VIX’s counterpart in Europe, the VStoxx Index, fell
0.6 percent to 15.15.

“Everybody has been expecting this VIX explosion and
that’s indicative by the call open interest,” Todd Salamone,
senior vice president of research at Schaeffer’s Investment
Research, said May 22 via phone from Cincinnati. “That’s just
an example of how cautious people are these days.”

Billionaire Petro Poroshenko won Ukraine’s presidential
election held over the weekend, handing him the task of stemming
deadly separatist violence that’s threatened to rip the former
Soviet republic apart. Russian President Vladimir Putin, who
doesn’t recognize the government in Kiev, has pledged to work
with the winner. The U.S. and its allies said they’d tighten
sanctions against Russia if voting was disrupted.

Retailers Miss

In the U.S. economy, bad weather and weak spending by
lower-income consumers has led retailers to miss first-quarter
earnings estimates by the widest margin in 13 years, according
to a report last week from researcher Retail Metrics Inc.

The overall stock market has shrugged off any concerns this
year about the economy or valuations. The S&P 500 jumped 1.2
percent last week to a record 1,900.53. The gauge trades at 17.5
times reported profit, near the highest level in four years.

The number of outstanding VIX calls is increasing partly
because of popular strategies used to speculate that it will
stay within a certain range, according to Rocky Fishman, equity
derivatives strategist at Deutsche Bank AG in New York. One of
those techniques is known as a call spread, when a trader buys
options at one strike price and offsets the cost by selling
contracts with a higher strike price.

Lacking Fear

“People don’t feel like they need to have the strongest
possible protection because they don’t expect a large shock to
the system,” Fishman said in a May 22 phone interview. “There
is a lack of fear in the market.”

To Jason Goepfert, president of Sundial Capital, the VIX
isn’t likely to remain at such low levels for much longer.

There have been 15 similar instances since 1986 when the
VIX was under 15 at least a month and held at least 14 percent
below its average level from the past 50 and 200 days, according
to a May 21 report from the Blaine, Minnesota-based research
firm. The VIX increased more than 20 percent every time in the
next three months and increased a median of 45 percent at the
highest points.

“It would be exceptionally unusual - unheard of, really -
to not see a spike in volatility in the coming months,”
Goepfert said in a note. “More likely sooner than later.”